A NEW European Union (EU) directive looks set to cause upheaval in the UK, German and Swedish insurance markets by giving priority protection, ahead of all other creditors, to retail and commercial policyholder claims in the event of a primary insurance company's insolvency. However, it is in the London Market where the impact of the directive may be most severely felt.
Most continental European markets already operate a system that explicitly favours policyholders. Now directive 2001/17/EC, which came into force in April, will extend the practice to
policyholders in the UK, Germany and Sweden. Debtholders and possibly reinsureds will become subordinate to primary policyholders.
In response to what will become the junior position of Debtholders, Standard & Poor's has announced a change in its rating criteria. Since May, the senior and explicitly subordinated debt obligations of insurance companies in each of the three domiciles affected have been rated at least one notch lower than their financial strength and counterparty credit ratings.
However, a more contentious development may arise through the implementation of the directive in the UK. Stemming from a lack of clarity relating to the treatment of reinsurance policyholders, the ultimate impact of the directive could even affect the way some insurance companies are structured.
The effect on London
We've noted that the directive, which only applies to insurance companies and not pure reinsurers, is unclear in how the regulations will apply to hybrid insurance and reinsurance companies that write a combined book of business.
There's an element of ambiguity in the new directive and, if a distinction is made between primary and secondary market policyholder obligations, then its effects may be felt most acutely in the London Market, where many companies traditionally write a mix of primary and secondary insurance, notably reinsurance.
By default, it has been left to the regulators in each affected country to clarify how the directive will be implemented. If, in the UK, the Financial Services Authority interprets it as to allow primary market policyholders formal precedence over an insolvent insurer's assets, then secondary or reinsurance market policyholders could be left in a subordinate position, and possibly only equal to other financial creditors.
The apparent danger for the London Market when the directive is implemented (which must not be later than April 2003) is that two classes of policyholder at hybrid insurance and reinsurance companies may be created: privileged primary policyholders, both retail and commercial, and a subordinate class of “other creditors”, including reinsurance cedants.
If those insurers relying on reinsurance cover from London Market companies with a combined book of business anticipate being in a weakened legal position, then some of them may prefer to turn to pure reinsurance companies for their main protection. This is likely to be particularly true where there is an increased risk of primary claims taking up the totality of the company's assets in the event of insolvency, leaving little or nothing to settle the legitimate claims of reinsurance cedants.
In such circumstances, the potential loss of business could prove damaging to some hybrid London Market companies. We expect that some may try to address the problem by restructuring their operations.
By dividing into two separate legal entities writing insurance and reinsurance respectively, the pure reinsurance element of the group will be able to avoid placing ceding company clients in a legally subordinate position.
Nevertheless, whether focused on the primary or the secondary markets, the restructured entities will still each need to be appropriately capitalised, reserved and managed.
While the extent of the directive's impact on the London Market is still uncertain, the criteria change has already had an impact on the wider insurance industry.
As Debtholders become secondary to policyholders in their right to claim assets from an insolvent insurer (under the guidelines set out by the proposal), it is inappropriate to continue rating primary insurance companies' financial strength and senior debt ratings at the same level. Consequently, the one-notch gapping criteria was introduced for the three countries affected by the directive.
We've also elected to extend the amended gapping criteria to primary insurers in Switzerland. Although the directive does not formally affect Switzerland as it is outside the EU, a review of Swiss law suggests that policyholder claims are privileged ahead of Debtholders and other creditors.
Despite the change to our criteria, the rating changes resulting from its application will be limited and should not be seen as constituting any intrinsic change in the credit strength of the respective issuers. As local law in most EU countries already gives explicit priority to policyholders, our senior debt ratings in these countries are already gapped down by one notch.
The low level of senior debt issuance by regulated insurance operating companies in Europe has also helped keep senior debt rating changes to a minimum.
The generally strong cash liquidity of insurance companies means that routine debt issuance is rare, while regulatory factors have encouraged most insurance-related debt to be issued either outside the regulated entity – notably by a holding company – or in a subordinated form. In both these circumstances, our ratings are already assigned at a lower level, reflecting either the explicit subordination of such debt or the perceived greater default risk of holding companies as issuers relative to their regulated operating subsidiaries.
As a consequence, only two senior debt ratings have been affected. In the UK, the rating on Royal & Sunalliance's commercial paper programme – with an authorised amount of $1bn (£703m) has been changed to A-1 from A-1+. Meanwhile, in Switzerland, the senior unsecured ratings on Zurich Finance (USA) and Zurich Finance (Bermuda), which are guaranteed by Zurich Insurance of Switzerland, have been changed to AA from AA+.
No ratings are affected in Sweden. Given their maturity in 2002, the $100m (£70.3m), 6.75% unsecured bonds issued by Skandia Capital and guaranteed by Skandia Insurance will have matured before local Swedish law is likely to be changed to accommodate the new directive. The current senior debt rating of BBB+ on these bonds, therefore has been affirmed.
Similarly, no ratings are affected in Germany. Reinsurers, rather than primary insurers, have issued the only operating company senior debt currently rated in Germany. All such debt is therefore outside the terms of the current directive and is not affected by our criteria change.